I recently read John Carreyrou's book Bad Blood, which outlines the rise and fall of the company Theranos. A brief summary for people who aren't familiar with the book: Theranos lied repeatedly about the capabilities of its blood testing technology. It fooled investors and partner companies. It then used an army of aggressive, well-paid lawyers to sue any attempted whistle-blowers. (It had legal standing to do this because it made all its employees sign strict non-disclosure forms.) Carreyrou's investigative reporting broke the story open and made it impossible for Theranos to keep fibbing about its technology.
Some people who are familiar with the story might take issue with my title. "Free markets working well? Didn't a private company fool its investors? Didn't it use private contracts to silence whistle-blowers?" Also, a major piece of evidence in Carreyrou's story was a government inspection report of a Theranos lab, which gave the company poor marks. So, didn't the regulatory state have a hand in bringing down Theranos? On the surface, this looks like a story about market actors behaving badly and government regulation reigning them in.
I think it's useful to think about what might have happened if Theranos faced no market discipline whatsoever. A short summary of the story might be: "Theranos lied to its investors." What's interesting about this is that Theranos felt some kind of obligation to impress investors. They had to find some way of getting other people to voluntarily give them money. In order to do that, they had to convince those investors of Theranos' vision of transforming medical testing. They had to make some kind of credible case that those investments would pay off. Theranos had to show their investors earnings reports and revenue projections. In the case of Theranos these reports were wildly optimistic, probably impossible, and certainly not done in good faith. Still, it's worth pausing for a moment to reflect on why Theranos saw any need to make such projections.
Imagine a world where a bad actor like Theranos doesn't even have to bother with these formalities. Imagine a medical firm can make wildly optimistic claims about the social value of its future products, unmoored by investor discipline of any kind. They get their allocation of funds, equipment, top scientists, and talented engineers paid top-level salaries year after year. It would be a tremendous waste of resources if this firm never had to show anything in return. It would be like the worst, most useless parts of academia, but now spread across the entire economy. Without investor discipline, profligate spending on useless projects goes on forever. Sure, maybe a free-market think-tank does a study pointing out the negative social return on such investments, or maybe a few investigative reporters write stories about labs that never produce anything of real value. But these labs simply fire back with vapid slogans about how "we must invest in our future." A public with a short attention span ignores the criticisms, not having the time to cost-benefit analyze every government program.
The Theranos debacle shows markets operating at their worst. A company lied to its investors and got away with it for a while. But does this impugn markets? Does corporate malfeasance at the 99.9th percentile impugn markets in general? Not really. What matters is what happened next. Theranos got its comeuppance, long before the government stepped in to fix the problem. Do we have proof that our system is a failure every time someone steals something? Every time some guy murders another guy? No, that would be silly. Problems happen in every society and under any system of government. What matters is how well problems are dealt with when they happen. What matters is how institutional arrangements create the right incentives, and how well these incentives avoid problems in the first place. The Theranos story is so compelling and news-worthy because it's so unusual.
Here's an analogy. I had a mouse in my house the other day. At first blush, my two cats failed. I jokingly sent a text to my wife saying "The cats are fired." On second thought, though, it was very useful to have cats around. They managed to chase the mouse under a cabinet and keep it trapped there. I couldn't find any evidence that the mouse got into our pantry, which means the mouse didn't have free reign to cause trouble. (We had mice in the house several months ago, so I know what that looks like.) Did the cats fail, because we had a mouse in the house? Or did they succeed, because as soon as a mouse got into the house they managed to trap it? I don't think I should judge my cats by a "mice never happen" standard, but rather by a "How quickly does a mouse scenario resolve itself?" standard. I read the Theranos story in the same light.
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